Analysis: Central Banks Buy Wiggle Room, Not Solution

Central bank action on Wednesday to ease severe funding strains for the world's private banks may help cushion a brewing global credit crunch but it only buys some wiggle room for governments trying to resolve the euro debt crisis and keep banks lending.

The intervention by top central banks from the world's richest countries — including the U.S. Federal Reserve, European Central Bank, Bank of Japan and Swiss National Bank — involved lowering the cost of emergency U.S. dollar funding for banks and expanding currency swap lines between countries.

Although partly aimed at easing seasonal year-end financing conditions in an already stressful environment, the move was an important show of unity among the central banks.

It also reveals the level of international official concern about the threat of the ongoing euro and banking crisis to global economic activity at large and comes the same day as China's central bank eased credit for its commercial lenders for the first time in three years.

The European Central Bank is also widely expected to cut interest rates again next week.

Although the instant market reaction to the moves was positive — equity, commodities and risky debt markets rallied while the dollar weakened — the moves underscore the close correlation between the euro crisis and a renewed banking crunch.

They illustrate the fear that both are combining to deliver another double whammy to world growth.

"There was a very dark mood developing at the back end of last week," said Mark Cliffe, chief economist at ING. "With the dire scenarios doing the rounds the last few days, it's all the more important they step in with aggressive measures to support the banking system and show they're beginning to confront the financing problems of the sovereigns as well."

RBS economist Silvio Peruzzo said the move was "very welcome" and "helps at the margin." Wayne Kaufman at New York firm John Thomas Financial said it was "all terrific news for short-term traders."

But does it change anything for investors increasingly bamboozled by the euro zone crisis and its threat to market risk sentiment.

A BIT OF HELP

On a technical level, the intervention makes it cheaper for non-U.S. banks to tap local central banks for dollars that have become increasingly scarce and expensive on open markets due to rising mistrust of bank balance sheet exposure to European government bonds.

"It's been clear for some time that funding in the dollar market has been drying up," said Richard Batty, investment director at Standard Life Investments in Edinburgh.

"Reducing funding costs and making more liquidity available is helpful. But the solvency issue remains."

The best illustration of current stress is the euro/dollar cross currency swap rate, which has soared since August to levels not seen since Lehman Brothers went bust in 2008. It fell back slightly after the central bank action Wednesday.

The problem for European banks and some others is that just as their previously "riskless" government assets are being questioned they are also are being forced to build capital ratios quickly, in Europe's case to a minimum 9 percent by the middle of next year.

But the balance sheet uncertainty makes raising new debt and equity finance for many banks almost impossible, or at least prohibitively expensive. The upshot is a reduction of lending and a selling of bonds and loans that is transmitting the squeeze to governments, businesses and households everywhere.

Some analysts estimate European banks could reduce lending by up to 3 trillion euros ($4.042 trillion) by the end of next year.

The upshot could see Western economies slip back into another recession next year and drag the developing world with them.

So market reaction to Wednesday's move was based on relief that someone was trying to do something about it.

"This is providing the banks with liquidity, playing the lender of the last resort for banks," said Jan Poser, chief economist at wealth manager Sarasin.

"It's not the cure. Equities are driven because people think after this action there won't be immediate bank failure and recession may be shallow."